Federal Reserve Bank Services, 67600-67620 [06-9333]

Agencies

• FEDERAL RESERVE SYSTEM

[Federal Register Volume 71, Number 225 (Wednesday, November 22, 2006)]
[Notices]
[Pages 67600-67620]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: 06-9333]


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FEDERAL RESERVE SYSTEM

[Docket No. OP-1269]


Federal Reserve Bank Services

AGENCY: Board of Governors of the Federal Reserve System.

ACTION: Notice.

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SUMMARY: The Board has approved the private sector adjustment factor 
(PSAF) for 2007 of $132.5 million and the 2007 fee schedules for 
Federal Reserve priced services and electronic access. These actions 
were taken in accordance with the requirements of the Monetary Control 
Act of 1980, which requires that, over the long run, fees for Federal 
Reserve priced services be established on the basis of all direct and 
indirect costs, including the PSAF. The Board has also approved 
maintaining the current earnings credit rate on clearing balances.

DATES: The new fee schedules and earnings credit rate become effective 
January 2, 2007.

FOR FURTHER INFORMATION CONTACT: For questions regarding the fee 
schedules: Jack K. Walton II, Associate Director, (202/452-2660); 
Jeffrey S.H. Yeganeh, Manager, Retail Payments, (202/728-5801); Edwin 
J. Lucio, Senior Financial Services Analyst, (202/736-5636),

[[Page 67601]]

Division of Reserve Bank Operations and Payment Systems. For questions 
regarding the PSAF and earnings credits on clearing balances: Gregory 
L. Evans, Assistant Director, (202/452-3945); Brenda L. Richards, 
Manager, Financial Accounting, (202/452-2753); Jonathan Mueller, Senior 
Financial Analyst, (202/530-6291); or Jonathan Senner, Senior Financial 
Analyst, (202/452-2042), Division of Reserve Bank Operations and 
Payment Systems. For users of Telecommunications Device for the Deaf 
(TDD) only, please call 202/263-4869. Copies of the 2007 fee schedules 
for the check service are available from the Board, the Federal Reserve 
Banks, or the Reserve Banks' financial services Web site at https://
www.frbservices.org.

SUPPLEMENTARY INFORMATION:

I. Private Sector Adjustment Factor and Priced Services

    A. Background--Each year, as required by the Monetary Control Act 
of 1980 (MCA), the Reserve Banks set fees for priced services provided 
to depository institutions. These fees are set to recover, over the 
long run, all direct and indirect costs and imputed costs, including 
financing costs, taxes, and certain other expenses, as well as return 
on equity (profit) that would have been earned if a private business 
firm provided the services. The imputed costs and imputed profit are 
collectively referred to as the PSAF. Similarly, investment income is 
imputed and netted with related direct costs associated with clearing 
balances to estimate net income on clearing balances (NICB). From 1996 
through 2005, the Reserve Banks recovered 98.4 percent of their total 
expenses (including special project costs and imputed costs) and 
targeted after-tax profits or return on equity (ROE) for providing 
priced services.\1\
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    \1\ The ten-year recovery rate is based upon the pro forma 
income statements for the Federal Reserve Banks' priced services 
published in the Board's Annual Report.
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    B. Discussion--Table 1 summarizes 2005, 2006 estimated, and 2007 
budgeted cost recovery rates for all priced services. Cost recovery is 
estimated to be 108.2 percent in 2006, which does not include the 
effects of FAS 158 discussed below, and budgeted to be 101.5 percent in 
2007. The performance of the check service heavily influences the 
aggregate cost recovery rates because the check service accounts for 
approximately 80 percent of the total cost of priced services. The 
electronic services (FedACHSM, the Fedwire[supreg] Funds 
Service and National Settlement Service (NSS), and the Fedwire[supreg] 
Securities Service) account for approximately 20 percent of total 
costs.\2\
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    \2\ FedACH and Fedwire are registered servicemarks of the 
Reserve Banks.
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    On September 29, 2006, the Financial Accounting Standards Board 
(FASB) issued a statement that significantly affects the Reserve Banks' 
priced services pro forma balance sheet as well as cost recovery in 
2006 and thereafter. Statement of Financial Accounting Standards No. 
158: Employers' Accounting for Defined Benefit Pension and Other 
Postretirement Plans (FAS 158) requires affected employers to record 
the actual funded status of their benefit plans on their balance sheets 
effective December 31, 2006, and any changes to the funded status in 
subsequent years. FAS 158 does not change the method used to 
periodically recognize these changes to the funded status of employers' 
benefit plans in the income statement. Because the Reserve Banks' 
benefit plans have net unrecognized losses, the existing 
``shareholders'' will incur a loss of value upon the initial adoption 
of FAS 158, which will be reflected in cost recovery beginning in 
2006.3, 4
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    \3\ As used in this context, the term ``shareholder'' does not 
refer to the actual member banks of the Federal Reserve System, but 
rather to the implied shareholders who would have an ownership 
interest if the Federal Reserve priced services were provided by a 
private firm.
    \4\ Before FAS 158, generally accepted accounting principles 
(GAAP) required employers with pension and other postretirement 
benefit plans to disclose the funded status of the plans in their 
financial statement footnotes.
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    These gains or losses that now must be recognized on the balance 
sheet stem from amendments to benefit plans, changes in actuarial and 
earnings assumptions, and differences between actuarial assumptions and 
actual experience. These factors can be highly volatile in any given 
year and, as a result, recognizing them could cause cost recovery to be 
significantly above or below 100 percent. To avoid short-run volatility 
in priced-services fees and their impact on the financial industry, 
past changes to these unrecognized gains or losses under FAS 158 will 
not be considered when setting priced-services fees, but they will 
continue to be factored into the fee setting process to the extent that 
they are recognized through the systematic approach required by GAAP. 
Future changes to these unrecognized gains or losses cannot be 
predicted and, therefore, cannot be considered in 2007 budgeted cost 
recovery. In light of the recent adoption of FAS 158, the Board will 
continue to study how incorporating these gains or losses affects its 
assessment of the Federal Reserve Banks' compliance with MCA's long-run 
cost recovery requirement.

                                      Table 1.--Aggregate Priced Services Pro Forma Cost and Revenue Performance a
                                                                      [$ millions]
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                                                                                                                                         5 \e\ Recovery
                                                                                     2 \c\ Total      3 Net income                         rate after
                             Year                                 1 \b\ Revenue        expense        (ROE) [1 - 2]   4 \d\ Target ROE  target ROE [1/(2
                                                                                                                                         + 4)] (percent)
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2005..........................................................             994.7             834.7             160.0             103.0             106.1
2006 (estimate)...............................................           1,020.2             871.0             149.2              72.0             108.2
2007 (budget).................................................             980.2             885.0              95.2              80.4            101.5
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\a\ Calculations in this table and subsequent pro forma cost and revenue tables may be affected by rounding.
\b\ Revenue includes net income on clearing balances (NICB). Clearing balances are assumed to be invested in a broad portfolio of investments, such as
  Treasury securities, government agency securities, commercial paper, municipal and corporate bonds, and money market and mutual funds. To impute
  income, a constant spread is determined from the historical average return on this portfolio and applied to the rate used to determine the cost of
  clearing balances. NICB equals the imputed income from these investments less earnings credits granted to holders of clearing balances. The cost of
  earnings credits is based on the discounted three-month Treasury bill rate.
\c\ The calculation of total expense includes operating, imputed, and other expenses. Imputed and other expenses include taxes, FDIC insurance, Board of
  Governors' priced services expenses, the cost of float, and interest on imputed debt, if any. Credits or debits related to the accounting for pensions
  under FAS 87 are also included.
\d\ Target ROE is the after-tax ROE included in the PSAF.

[[Page 67602]]

 
\e\ Cost recovery is estimated to be 77.2 percent in 2006, including the estimated loss of $378 million resulting from the implementation of FAS 158.
  Future changes to these unrecognized items cannot be estimated.

    Table 2 presents an overview of cost recovery by service line for 
2005 through 2007.

                                     Table 2.--Priced Services Cost Recovery
                                                    [percent]
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                                                                                2006 Estimate
             Priced service                     2005           2006 Budget           \a\         2007 Budget \b\
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All services............................             106.1             102.6             108.2             101.5
Check...................................             106.1             102.4             109.1             101.5
FedACH..................................             106.4             101.0             101.1             101.6
Fedwire Funds and NSS...................             106.7             105.4             109.1             102.3
Fedwire Securities......................             104.7             105.6             103.7            101.6
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\a\ Including the FAS 158 effect, the reported recovery rates are: All services--77.2%, Check--78.0%, FedACH--
  72.6%, Fedwire Funds and NSS--78.6%, and Fedwire Securities--65.1%.
\b\ 2007 budget figures reflect the most recent data from Reserve Banks. The Reserve Banks will transmit final
  budget data to the Board in November 2006, for Board consideration in December 2006.

    1. 2006 Estimated Performance--The Reserve Banks estimate that they 
will recover 108.2 percent (77.2 percent including the effects of FAS 
158) of the costs of providing priced services, including imputed 
expenses and targeted ROE, compared with a budgeted recovery rate of 
102.6 percent, as shown in table 2. The Reserve Banks estimate that 
they will exceed $1 billion in revenue for the first time and that all 
services will achieve full cost recovery, excluding the effects of FAS 
158. The Reserve Banks estimate that they will fully recover actual and 
imputed expenses and earn net income of $149.2 million compared with 
the target of $72.0 million. The greater-than-expected net income is 
largely driven by the performance of the check service, which had 
greater-than-expected Check 21 and paper return volumes, as well as 
greater-than-expected net income on clearing balances.
    Other than the effects of FAS 158, greater-than-expected Check 21 
volume has been the single most significant factor influencing priced 
services cost recovery as additional fee revenue has exceeded the costs 
of processing the unexpected volumes. The Reserve Banks have also 
continued their efforts to downsize their paper check-processing 
infrastructure as paper check volumes continue to decline nationwide. 
The Reserve Banks have already reduced the number of sites at which 
they process checks from forty-five in 2003 to twenty-two in 2006 and 
will discontinue processing checks at four other offices by early 2008. 
These check restructuring efforts have enabled the Reserve Banks to 
return to full cost recovery by reducing costs in line with the decline 
in revenues associated with paper check processing.
    2. 2007 Private Sector Adjustment Factor--The 2007 PSAF for Federal 
Reserve priced services is $132.5 million. This amount represents an 
increase of $14.8 million from the 2006 PSAF of $117.7 million. This 
increase is primarily due to an increase in the cost of equity.\5\
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    \5\ The cost of equity increased due to an increase in the ROE, 
which is slightly offset by a reduction in imputed equity.
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    3. 2007 Projected Performance--The Reserve Banks project a priced 
services cost recovery rate of 101.5 percent. The 2007 fees for priced 
services are projected to result in a net income of $95.2 million 
compared with the $80.4 million required to achieve full cost recovery. 
The major risks to the Reserve Banks' ability to achieve their budget 
targets are a greater decline in the Reserve Banks' paper check volume 
than the projected 24.0 percent, unanticipated problems with 
technological upgrades that could result in significant cost overruns, 
and lower-than-expected electronic payments volumes due to competition. 
In light of these risks, the Reserve Banks will continue to refine 
their business and operational strategies to improve efficiency and 
reduce excess capacity and other costs. These efforts should position 
the Reserve Banks to achieve their financial and other payment system 
objectives and statutory requirements over the long run.
    4. 2007 Pricing--The following summarizes the changes in the 
Reserve Banks' fee schedules for priced services in 2007:
Check
     The Reserve Banks will raise paper check fees for forward 
collection check products 5.0 percent, return check products 9.6 
percent, and payor bank check products 8.1 percent.
     The Reserve Banks will decrease Check 21 fees for 
FedForward products delivered to electronic endpoints 12.5 percent but 
to increase Check 21 fees for FedForward products delivered to 
substitute-check endpoints 3.1 percent. The Reserve Banks also will 
offer a restructured deposit discount of $0.003 for each check 
presented through FedReceipt products. FedReturn fees will remain 
unchanged.
     With the 2007 fee changes, the price index for the check 
service will have increased 57 percent since 1997.
FedACH
     The Reserve Banks will increase the monthly subscription 
fee for the Informational Extract File from $10 to $20.
     With the 2007 fee change, the price index for the FedACH 
service will have decreased 65 percent since 1997.
Fedwire Funds and National Settlement Services
     The Reserve Banks will raise the surcharge for offline 
funds transfers from $20 to $30 and to decrease the online transfer fee 
by one cent in all pricing tiers.
     With the 2007 fee changes, the price index for the Fedwire 
Funds and National Settlement Services will have decreased 55 percent 
since 1997.
Fedwire Securities Service
     The Reserve Banks will increase the online transfer fee by 
two cents, the monthly maintenance fee from $15 to $16, and the 
surcharge for offline securities transfers from $50 to $60.
     With the 2007 fee changes, the price index for the Fedwire 
Securities Service

[[Page 67603]]

will have decreased 46 percent since 1997.
    5. 2007 Price Index--Figure 1 compares indexes of fees for the 
Reserve Banks' priced services with the GDP price index. The price 
index for all Reserve Bank priced services is projected to increase 1.0 
percent in 2007, compared with the 2.3 percent growth anticipated in 
2006. The price index for paper check and electronic payment services 
in 2007 are projected to increase 6.0 percent and 0.1 percent, 
respectively. Based on 2006 data available to date, the price index for 
all priced services is expected to increase an estimated 20.3 percent 
from 1997 to 2006, compared with an estimated 22.0 percent growth in 
the GDP price index over the same period.\6\
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    \6\ In the first half of 2006, the GDP price index grew at an 
annualized rate of 3.3 percent.

BILLING CODE 6210-01-P

FIGURE 1

PRICE INDEXES FOR FEDERAL RESERVE PRICED SERVICES

[[Page 67604]]

[GRAPHIC] [TIFF OMITTED] TN22NO06.013

    C. Private Sector Adjustment Factor--The method for calculating the 
financing and equity costs in the PSAF requires determining the 
appropriate levels of debt and equity to impute and then applying the 
applicable financing

[[Page 67605]]

rates. In this process, a pro forma priced services balance sheet using 
estimated Reserve Bank assets and liabilities associated with priced 
services is developed, and the remaining elements that would exist if 
the Reserve Banks' priced services were provided by a private business 
firm are imputed. The same generally accepted accounting principles 
that apply to commercial entity financial statements also apply to the 
relevant elements in the priced services pro forma financial 
statements.
    The amount of the Reserve Banks' assets that will be used to 
provide priced services during the coming year is determined using 
Reserve Bank information on actual assets and projected disposals and 
acquisitions. The priced portion of assets is determined based on the 
allocation of the related depreciation expense. The priced portion of 
actual Reserve Bank liabilities consists of balances held by Reserve 
Banks for clearing priced-services transactions (clearing balances), 
and other liabilities such as accounts payable and accrued expenses.
    Long-term debt is imputed only when core clearing balances and 
long-term liabilities are not sufficient to fund long-term assets or if 
the interest rate risk sensitivity analysis, which measures the 
interest rate effect of the difference between interest rate sensitive 
assets and liabilities, indicates that a 200 basis point change in 
interest rates would change cost recovery more than two percentage 
points.\7\ Short-term debt is imputed only when short-term liabilities 
and clearing balances not used to finance long-term assets are 
insufficient to fund short-term assets. Equity is imputed to meet the 
FDIC definition of a well-capitalized depository institution for 
insurance premium purposes and represents the market capitalization, or 
shareholder value, for priced services.8 9
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    \7\ A portion of clearing balances is used as a funding source 
for priced-services assets. Long-term assets are partially funded 
from core clearing balances, which are currently $4 billion. Core 
clearing balances are considered the portion of the balances that 
has remained stable over time without regard to the magnitude of 
actual clearing balances.
    \8\ As mentioned in footnote 3, the term ``shareholder'' does 
not refer to the actual member banks of the Federal Reserve System, 
but rather to the implied shareholders who would have an ownership 
interest if the Federal Reserve priced services were provided by a 
private firm.
    \9\ The FDIC requirements for a well-capitalized depository 
institution are (1) a ratio of total capital to risk-weighted assets 
of 10 percent or greater; and (2) a ratio of Tier 1 capital to risk-
weighted assets of 6 percent or greater; and (3) a leverage ratio of 
Tier 1 capital to total assets of 5 percent or greater. The Federal 
Reserve priced services balance sheet has no components of Tier 1 or 
total capital other than equity; therefore, requirements 1 and 2 are 
essentially the same measurement.
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    1. Financing rates--Equity financing rates are based on the target 
return on equity (ROE) result of the capital asset pricing model 
(CAPM). In the CAPM, the required rate of return on a firm's equity is 
equal to the return on a risk-free asset plus a risk premium. To 
implement CAPM, the risk-free rate is based on the three-month Treasury 
bill, the beta is assumed to be equal to 1.0, which approximates the 
risk of the market as a whole, and the monthly returns in excess of the 
risk-free rate over the most recent 40 years are used as the market 
risk premium. The resulting ROE influences the dollar level of the PSAF 
because this is the return a shareholder would expect in order to 
invest in a private business firm.
    For simplicity, given that federal corporate income tax rates are 
graduated, state income tax rates vary, and various credits and 
deductions can apply, a specific income tax expense is not calculated 
for Reserve Bank priced services. Instead, the Board targets a pre-tax 
ROE that would provide sufficient income to fulfill its income tax 
obligations.\10\ To the extent that the actual performance results are 
greater or less than the targeted ROE, income taxes are adjusted using 
an imputed income tax rate. Because the Reserve Banks provide similar 
services through their correspondent banking activities, including 
payment and settlement services, and equity is imputed to meet the FDIC 
requirements of a well-capitalized depository institution, the imputed 
income tax rate is the median of the rates paid by the top fifty bank 
holding companies (BHCs) based on deposit balance over the past five 
years adjusted to the extent that they invested in tax-free municipal 
bonds.
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    \10\ Other taxes, such as sales taxes, are included in priced-
services actual or imputed costs.
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    2. Other Costs--The PSAF also includes the estimated priced 
services-related expenses of the Board of Governors and imputed sales 
taxes based on Reserve Bank estimated expenditures. An assessment for 
FDIC insurance, when required, is imputed based on current FDIC rates 
and projected clearing balances held with the Federal Reserve.
    3. Net Income on Clearing Balances--The NICB calculation is made 
each year along with the PSAF calculation and is based on the 
assumption that Reserve Banks invest clearing balances net of imputed 
reserve requirements and balances used to finance priced-services 
assets. Using these net clearing balance levels, Reserve Banks impute a 
constant spread, determined by the return on a portfolio of 
investments, over the three-month Treasury bill rate.11 12 
The calculation also involves determining the priced-services cost of 
earnings credits (amounts available to offset service fees) on 
contracted clearing balances held, net of expired earnings credits, 
based on a discounted Treasury bill rate. Rates and clearing balance 
levels used in the NICB estimate are based on the most-recent rates and 
clearing balance levels.\13\ Because clearing balances are held for 
clearing priced-services transactions or offsetting priced-services 
fees, they are directly related to priced services. The net earnings or 
expense attributed to the investments and the cost associated with 
holding clearing balances, therefore, are considered net income for 
priced services activities.
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    \11\ The investment portfolio is composed of investments 
comparable to a BHC's investment holdings, such as short-term 
Treasury securities, government agency securities, commercial paper, 
long-term corporate bonds, and money market funds. See table 7 for 
the investments imputed in 2007.
    \12\ NICB is projected to be $139.6 million for 2007 using a 
constant spread of 29 basis points over the three-month Treasury 
bill, and applying this rate to the clearing balance levels used in 
the 2007 pricing process. The 2006 NICB estimate is $113.2 million.
    \13\ July 2006 rates and balances were used to estimate the 2007 
NICB.
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    4. Adopting FAS 158--On September 29, 2006, FASB issued FAS 158: 
Employers'' Accounting for Defined Benefit Pension and Other 
Postretirement Plans. This statement, effective for fiscal years ending 
after December 15, 2006, requires affected employers to show the actual 
funded status of their benefit plans by recognizing the deferred 
elements related to pension and postretirement accounting as 
adjustments to the related assets or liabilities on their balance 
sheets. These deferred elements include unrecognized gains or losses 
(resulting from changes in actuarial assumptions, such as the discount 
rate, and differences between these assumptions and actual experience) 
and prior service costs or credits (resulting from amendments to 
existing benefit plans).\14\ FAS 158 does not change the method used to 
periodically recognize these deferred elements in the income statement.
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    \14\ Previously, GAAP required employers with pension and other 
postretirement benefit plans to disclose these deferred elements in 
their financial statement footnotes.
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    Because the Reserve Banks offer employees defined benefit pension 
and other postretirement benefits, the adoption of FAS 158 will affect 
the Reserve Banks' 2006 balance sheets and financial statement 
disclosures. Given that these benefits are provided to employees 
involved in priced services,

[[Page 67606]]

the effects of the new accounting standard must also be included in the 
pro forma priced services balance sheet.\15\ The current estimate is 
net unrecognized losses for the December 31, 2006, deferred elements.
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    \15\ The costs associated with pension and postretirement 
benefits as recognized under GAAP have always been allocated to the 
priced services income statement as direct or indirect expense 
items.
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    To reflect the funded status of the Reserve Banks' benefit plans on 
the 2006 pro forma priced services balance sheet as required by FAS 
158, the Reserve Banks will record a reduction in the prepaid pension 
asset.\16\ The offset to the asset reduction will be twofold: The 
amount by which the pension asset is reduced, net-of-tax, will be 
reported as a negative component of equity called accumulated other 
comprehensive income (AOCI), while the remainder will be reported as a 
deferred tax asset.\17\ Similarly, the full unfunded status of the 
postretirement benefits liability must be recognized by increasing the 
liability on the priced services pro forma balance sheet, with the 
offsetting net-of-tax portion of this entry reflected in AOCI and the 
balance assigned to the deferred tax asset.\18\ Because priced-services 
equity is imputed at the minimum level necessary to meet the FDIC 
definition of a well-capitalized depository institution, any direct 
reduction to equity through AOCI as a result of FAS 158 will require 
the Reserve Banks to impute additional equity.19, 20
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    \16\ Although recognizing the deferred elements will result in a 
decrease to the pension asset and equity in 2006, the Reserve Banks 
could have increases or decreases to these balance sheet items in 
future years.
    \17\ Other financial accounting standards require that future 
tax consequences of events be recognized in an entity's financial 
statements. FAS 158 requires employers to compute the AOCI 
adjustment net-of-tax.
    \18\ Although recognizing the deferred elements would result in 
an increase to the benefits liability and decrease to equity in 
2006, the Reserve Banks could have increases or decreases to these 
balance sheet items in future years.
    \19\ Under current reporting requirements, FAS 158 adjustments 
to equity via AOCI would be included in the calculation of Tier 1 
capital for regulatory purposes, thus reducing priced-services 
equity to below the well-capitalized threshold.
    \20\ The Federal Reserve priced services could elect to restore 
equity to an adequate, but less than well-capitalized, level and 
incur the resulting FDIC assessment.
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    It is unclear whether a private firm with a similar balance sheet 
would actually raise additional equity to offset the FAS 158 balance 
sheet changes. Because most BHCs hold capital balances in excess of the 
minimum level to be considered well-capitalized, and because their 
pension assets and liabilities represent a comparatively small share of 
total equity, they may be able to absorb the FAS 158 adjustments and 
still maintain adequate regulatory capital levels.
    For the purpose of measuring priced-services cost of equity, the 
Reserve Banks assume that existing shareholders will sustain an 
economic loss of value as a result of implementing the FAS 158 
accounting changes.\21\ This assumption implies that these shareholders 
will expect a return on only the remaining portion of their investment 
(original investment amount less AOCI reduction) and that the new 
equity investors will expect a similar return on their investment. This 
will leave the cost of equity, and overall PSAF, virtually unchanged 
from what it was before the application of FAS 158, because the 
existing shareholder investment that was eliminated by the AOCI 
reduction will be replaced by the new equity required to replenish 
total equity to 5 percent of total assets and remain well-capitalized 
according to FDIC guidelines. NICB will increase, however, because this 
new equity will be available for investment.
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    \21\ The value of equity reported in the pro forma priced 
services balance sheet is assumed to equal the market value of 
equity. Because priced-services fees are set to maintain this 
implied shareholder value (that is, not to substantially over or 
underrecover), the targeted ROE equals the market return these 
shareholders would expect priced services to earn, or recover, each 
year.
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    Because the Reserve Bank benefit plans have net unrecognized 
losses, the Reserve Bank priced services will recognize this reduction 
in value in cost recovery for 2006. The Reserve Bank priced services 
assume that existing shareholders incur these losses upon the initial 
implementation of FAS 158, with the losses flowing to the shareholders 
rather than to the firm itself. Prices for 2007 and thereafter, 
however, will be set to achieve full cost recovery over the long run 
before the annual FAS 158 adjustments, with a measure of cost-recovery 
performance provided for each year that includes the FAS 158 
adjustment. This approach will limit the increased year-to-year price 
volatility that would result from including annual FAS 158 adjustments 
in the setting of priced-services fees. It is also consistent with the 
FASB's systematic approach of deferring recognition of prior service 
costs or credits and actuarial gains or losses to reduce the inherent 
volatility of these deferred items on current expense.
    Including the annual FAS 158 adjustment in a measurement of priced 
services cost recovery, however, could produce highly variable actual 
cost recovery results from year-to-year that exceed or fall short of 
100 percent. One component of the annual FAS 158 entry is unrecognized 
prior service cost, which arises from certain amendments to existing 
benefit plans and is amortized according to GAAP over a specific period 
(usually twelve to fifteen years). This factor will have a negligible 
effect on reported long-run cost recovery because the initial 
recognition of prior service cost (a negative adjustment to cost 
recovery) should eventually be offset by positive adjustments to cost 
recovery as this cost is amortized over time and incorporated into the 
price-setting process. The other component of the annual FAS 158 entry, 
unrecognized gains or losses, results from changes in actuarial 
assumptions (discount rates, return on plan assets, demographic 
changes, and so on) and differences between these assumptions and 
actual experience. These actuarial gains or losses could be highly 
volatile and may or may not offset each other for as long as the 
Federal Reserve continues to offer pension and postretirement benefits. 
For this reason, GAAP does not require the recognition of these gains 
or losses until they exceed a corridor of 10 percent of the greater of 
the benefit obligations or assets. In addition, because these factors 
and the resulting year-to-year changes in the associated assets and 
liabilities are not measured until after year-end and cannot be 
estimated for pricing purposes, long-run cost recovery could be greater 
or less than 100 percent depending on the amount of the actuarial gains 
or losses that are recognized each year.
    5. Analysis of the 2007 PSAF--The increase in the 2007 PSAF is 
primarily due to an increase in the required ROE result provided by the 
CAPM, which offsets an overall reduction in imputed equity.
    a. Asset Base--The estimated 2007 Federal Reserve assets, reflected 
in table 3, have decreased $1,303.0 million. There is a decline in 
imputed investments in marketable securities of $1,118.1 million and in 
imputed reserve requirements of $163.5 million, which are imputed based 
on the estimated level of clearing balances held, and in the prepaid 
pension asset of $446.9 million as a result of the FAS 158 accounting 
changes. These declines are slightly offset by an increase in items in 
process of collection of $262.2 million, due to higher estimated float 
receivables, and in the deferred tax asset associated with implementing 
FAS 158 of $159.3 million.
    As shown in table 4, the assets financed through the PSAF have 
decreased. Short-term assets funded with short-term payables and 
clearing

[[Page 67607]]

balances total $10.2 million. This represents an $18.2 million decrease 
from the short-term assets funded in 2006 due to an increase in 
expected short-term payables. Long-term liabilities and equity are 
greater than long-term assets; therefore, no core clearing balances are 
used to fund long-term assets.
    b. Debt and Equity Costs and Taxes--As previously mentioned, core 
clearing balances are available as a funding source for priced-services 
assets. Table 4 shows that $10.2 million in clearing balances is used 
to fund priced-services assets in 2007. The interest rate sensitivity 
analysis in table 5 indicates that a 200 basis point decrease in 
interest rates affects the ratio of rate-sensitive assets to rate-
sensitive liabilities and produces a decrease in cost recovery of 1.4 
percentage points, while an increase of 200 basis points in interest 
rates increases cost recovery by 1.5 percentage points. The established 
threshold for a change in cost recovery is two percentage points; 
therefore, interest rate risk associated with using these balances is 
within acceptable levels and no long-term debt is imputed.
    Table 6 shows the imputed PSAF elements, the pretax ROE, and other 
required PSAF costs for 2006 and 2007. The increase in ROE is primarily 
caused by an increase in the risk-free rate of return. Sales taxes 
increased from $7.7 million in 2006 to $8.5 million in 2007. The 
effective income tax rate used in 2007 increased to 31.5 percent from 
29.8 percent in 2006. The priced-services portion of the Board's 
expenses decreased $0.8 million from $7.5 million in 2006 to $6.7 
million in 2007.
    c. Capital Adequacy and FDIC Assessment--As shown in table 3, the 
amount of equity imputed for the 2007 PSAF is $742.9 million, a 
decrease of $65.1 million versus the imputed equity for 2006. This 
includes additional imputed equity of $361.0 million to offset the FAS 
158 reduction to AOCI.
    In 2007, the capital to total assets ratio and the capital to risk-
weighted assets ratio both meet or exceed regulatory guidelines as 
required by the FDIC definition of a well-capitalized depository 
institution for insurance premium purposes. Equity is based on 5 
percent of total assets, and capital to risk-weighted assets is 15.0 
percent. Based on the final regulations recently adopted by the FDIC, 
the Reserve Bank priced services estimate a one-time assessment credit 
of $16.6 million. Because the estimated assessment for 2007 does not 
exceed the one-time assessment credit, no net FDIC assessment is 
imputed for 2007.

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    D. Earnings Credits on Clearing Balances--The Board has approved 
maintaining the current rate of 80 percent of the three-month Treasury 
bill rate to calculate earnings credits on clearing balances.\39\ The 
Reserve Banks

[[Page 67613]]

will continue to calculate earnings credits (amounts available to 
offset service fees) for the marginal reserve requirement adjusted 
portion of clearing balances at the federal funds rate.\40\
---------------------------------------------------------------------------

    \39\ Two adjustments are applied to the earnings credit rate so 
that the return on clearing balances at the Federal Reserve is 
comparable to what the depository institution (DI) would have earned 
had it maintained the same balances at a private-sector 
correspondent. The ``imputed reserve requirement'' adjustment is 
made because a private-sector correspondent would be required to 
hold reserves against the respondent's balance with it. As a result, 
the correspondent would reduce the balance on which it would base 
earnings credits for the respondent because it would be required to 
hold a portion, determined by its marginal reserve ratio, in the 
form of non-interest-bearing reserves. For example, if a DI held $1 
million in clearing balances with a correspondent bank and the 
correspondent had a marginal reserve ratio of 10 percent, then the 
correspondent bank would be required to hold $100,000 in reserves, 
and it would typically grant credits to the respondent based on 90 
percent of the balance, or $900,000. This adjustment imputes a 
marginal reserve ratio of 10 percent to the Reserve Banks.
    The ``marginal reserve requirement'' adjustment accounts for the 
fact that the respondent can deduct balances maintained at a 
correspondent, but not the Federal Reserve, from its reservable 
liabilities. This reduction has value to the respondent when it 
frees up balances that can be invested in interest-bearing 
instruments, such as federal funds. For example, a respondent 
placing $1 million with a correspondent rather than the Federal 
Reserve would free up $30,000 if its marginal reserve ratio were 3 
percent.
    The formula used by the Reserve Banks to calculate earnings 
credits can be expressed as e = [ b * (1-FRR) * r] + [ b * (MRR) * 
f]
    Where e is total earnings credits, b is the average clearing 
balance maintained, FRR is the assumed Reserve Bank marginal reserve 
ratio (10 percent), r is the earnings credit rate, MRR is the 
marginal reserve ratio of the DI holding the balance (either 0 
percent, 3 percent, or 10 percent), and f is the average federal 
funds rate. A DI that meets its reserve requirement entirely with 
vault cash is assigned a marginal reserve requirement of zero.
    \40\ This calculation adjusts earnings credits as though account 
holders could adjust their reserve requirement for a ``due from 
deduction'' for clearing balances held with a Reserve Bank.
---------------------------------------------------------------------------

    Clearing balances were introduced in 1981, as a part of the Board's 
implementation of the Monetary Control Act, to facilitate access to 
Federal Reserve priced services by institutions that did not have 
sufficient reserve balances to support the settlement of their payment 
transactions. The earnings credit calculation uses a percentage 
discount on a rolling thirteen-week average of the annualized coupon 
equivalent yield of three-month Treasury bills in the secondary market. 
Earnings credits, which are calculated monthly, can be used only to 
offset charges for priced services and expire if not used within one 
year.\41\
---------------------------------------------------------------------------

    \41\ A band is established around the contracted clearing 
balance to determine the maximum balance on which credits are earned 
as well as any deficiency charges. The clearing balance allowance is 
2 percent of the contracted amount, or $25,000, whichever is 
greater. Earnings credits are based on the period-average balance 
maintained up to a maximum of the contracted amount plus the 
clearing balance allowance. Deficiency charges apply when the 
average balance falls below the contracted amount less the 
allowance, although credits are still earned on the average 
maintained balance.
---------------------------------------------------------------------------

    E. Check Service--Table 8 below shows the 2005, 2006 estimate, and 
2007 budgeted cost recovery performance for the commercial check 
service.

                             Table 8.--Check Pro Forma Cost and Revenue Performance
                                                  [$ millions]
----------------------------------------------------------------------------------------------------------------
                                                                                                    5  Recovery
                                                                                                    rate  after
              Year                  1  Revenue       2  Total      3  Net income  4  Target  ROE    target  ROE
                                                      expense      (ROE)  [1-2]                     [1/(2 + 4)]
                                                                                                     (Percent)
----------------------------------------------------------------------------------------------------------------
2005............................           817.5           688.7           128.7            82.0           106.1
2006 (estimate).................           837.4           710.8           126.6            57.1         a 109.1
2007 (budget)...................           784.3           709.9            74.4            63.2           101.5
----------------------------------------------------------------------------------------------------------------
a Including FAS 158, the estimated cost recovery for the check service is 78.0%.

    1. 2006 Estimate--For 2006, the Reserve Banks estimate that the 
check service will recover 109.1 percent of total expenses and targeted 
ROE, compared with the budgeted recovery rate of 102.4 percent. The 
Reserve Banks expect to recover all actual and imputed expenses of 
providing check services and earn net income of $126.6 million (see 
table 8).
    The higher-than-budgeted cost recovery is the result of revenue 
that was $103.0 million higher than expected, which was partially 
offset by expenses that were $50.7 million greater than budgeted. The 
higher revenue is due to greater-than-budgeted electronic check 
collection and paper check return volumes, as well as greater-than-
expected NICB. The higher costs were largely due to greater-than-
budgeted personnel and materials costs related to Check 21 substitute 
check printing, pension costs, and imputed taxes.
    The greater-than-expected electronic check volume can be attributed 
to faster-than-anticipated adoption of Check 21 products. The number of 
checks deposited and presented electronically has grown steadily in 
2006 (see table 9). Year-to-date through August 2006, 10.3 percent of 
the Reserve Banks'' volume was deposited and 2.2 percent was presented 
using Check 21 products.\42\ Depository institutions have been slower 
to accept check presentments electronically because financial 
incentives are generally stronger for electronic check deposit and 
because integrating electronic presentments into back-office processing 
and risk-management systems can be a complex and expensive undertaking.
---------------------------------------------------------------------------

    \42\ The Reserve Banks also offer non-Check 21 electronic 
presentment products. In August 2006, 26.0 percent of the Reserve 
Banks' deposit volume was presented to paying banks using these 
products. The majority of checks presented through non-Check 21 
electronic presentment products are delivered to the paying banks.
---------------------------------------------------------------------------

    Year-to-date figures, however, understate the current penetration 
rate of Check 21 products, as volume has increased throughout 2006. In 
August 2006, the Check 21 deposit penetration rate rose to 16.6 
percent. This volume represents 42 percent of the value of checks 
collected through the Reserve Banks because many depository 
institutions are using Check 21 products to collect their higher value 
checks more rapidly. Recent trends, however, indicate that the average 
value of checks deposited using Check 21 products will decline because 
an increasing number of depository institutions are choosing to clear 
all of their checks using these products.
---------------------------------------------------------------------------

    \43\ The Reserve Banks' Check 21 product suite includes 
FedForward, FedReturn, and FedReceipt. FedForward is the electronic 
alternative to forward check collection; FedReturn is the electronic 
alternative to paper check return; and FedReceipt products are 
electronic receipt of Check 21 items. Under FedReceipt, the Reserve 
Banks electronically present only the checks that were deposited 
electronically or that were deposited in paper form and converted 
into electronics by the Reserve Banks. Under FedReceipt Plus, the 
Reserve Banks electronically present all checks drawn on the 
customer.

[[Page 67614]]



                                 Table 9.--Check 21 Product Penetration Rates 43
                                                   [Percent] a
----------------------------------------------------------------------------------------------------------------
                                                                                    August 2006     August 2006
                                                                       2005        year-to-date       actual
----------------------------------------------------------------------------------------------------------------
Deposit.........................................................             1.9            10.3            16.6
    FedForward..................................................             1.6             9.4            15.5
    Paper to Check 21...........................................             0.3             0.9             1.0
Presentment.....................................................             0.0             2.2             4.8
    FedReceipt..................................................             0.0             0.1             0.1
    FedReceipt Plus.............................................             0.0             2.1             4.7
Return:
    FedReturn...................................................             3.7            14.5            21.4
----------------------------------------------------------------------------------------------------------------
a Deposit and presentment statistics are calculated as a percentage of total forward collection volume. Return
  statistics are calculated as a percentage of total return volume.

    For full-year 2006, the Reserve Banks estimate that paper forward-
collection volume will decline 17.1 percent compared with a budgeted 
decline of 14.0 percent as more volume is deposited electronically (see 
table 10). Through August, paper forward-collection volume has 
decreased 16.6 percent compared with the same period in 2005. Through 
August, paper return check volume has decreased 17.5 percent from the 
same period in 2005. The Reserve Banks estimate that paper return 
volume will decline 21.2 percent for the full year compared with a 
budgeted decline of 31.7 percent.

                                  Table 10.--Paper Check Product Volume Changes
                                                    [Percent]
----------------------------------------------------------------------------------------------------------------
                                                                                   Actual change
                                                                   Budgeted 2006      through     Estimated 2006
                                                                      change        August 2006       change
----------------------------------------------------------------------------------------------------------------
Total forward collection........................................           -14.0           -16.6           -17.1
Returns.........................................................           -31.7           -17.5           -21.2
----------------------------------------------------------------------------------------------------------------

    2. 2007 Pricing--In 2007, the Reserve Banks project that the check 
service will recover 101.5 of total expenses and targeted ROE.
    Revenue is projected to be $784.3 million, a decline of 6.2 percent 
compared with the 2006 estimate. This decline is driven by a $121.7 
million drop in paper check fee revenue that is partially offset by a 
$52.7 million increase in Check 21 fee revenue.
    Total expenses for the check service are projected to be $709.9 
million, representing a $0.9 million decline. Increases in the pension 
costs and one-time expenses associated with the Check 21 initiative and 
the consolidation of check-processing offices will be offset by ongoing 
cost savings associated with projected declines in paper-check volume 
and efficiency improvements at restructuring sites. These cost 
reductions should enable the Reserve Banks to maintain full cost 
recovery. A key driver in the reduction of local check costs is the 
planned restructuring of four more check-processing sites by the second 
quarter of 2008.\44\
---------------------------------------------------------------------------

    \44\ In February 2003, the Reserve Banks announced an initiative 
to reduce the number of sites at which they process checks from 
forty-five to thirty-two. The Reserve Banks announced further rounds 
of restructurings in August 2004, May 2005, and May 2006. By the end 
of these announced restructurings in early 2008, the Reserve Banks 
will have eighteen check processing sites.
---------------------------------------------------------------------------

    The Reserve Banks project that paper-check volume for forward 
products will decrease 24.0 percent, volume for return products will 
decrease 21.3 percent, and volume for payor bank products will decrease 
5.5 percent. These expected volume declines will be partially offset by 
a projected increase in Check 21 volumes (see table 11). The Reserve 
Banks project that FedForward volume will increase 97.1 percent, 
FedReturn volume will increase 112.3 percent and FedReceipt Plus volume 
will increase 342.8 percent. The Reserve Banks' projected increase in 
Check 21 volume will result in a 49.5 percent increase in Check 21 
product revenue to about $159 million. Board and Reserve Bank staff 
believe that the key to realizing Check 21 cost efficiencies for the 
System continues to be the widespread acceptance of electronic check 
presentments by paying banks.

                       Table 11.--Check 21 Volume
------------------------------------------------------------------------
                                           2007 Budgeted
                                              volume        Growth from
                                           (millions of    2006 estimate
                                              items)         (percent)
------------------------------------------------------------------------
FedForward..............................         2,636.4            97.1
FedReturn...............................            44.7           112.3
FedReceipt Plus.........................         1,686.8           342.8
------------------------------------------------------------------------


[[Page 67615]]

    In 2007, the Reserve Banks will continue to encourage the adoption 
of electronic check collection and presentment alternatives through 
price increases to paper-check products and price reductions for 
strategic electronic products. The price increases for paper products 
generally are distributed across most product categories, with 
generally higher price increases for nonstrategic product lines. The 
Reserve Banks also will continue to narrow the price ranges for similar 
products across the System. In addition, the Reserve Banks will offer 
depository institutions greater incentives to deposit and accept checks 
electronically. As the use of Check 21-related products increases, the 
prices of paper products may be raised further to encourage adoption of 
electronic check collection and presentment alternatives.
    For 2007, the Reserve Banks are targeting an overall price increase 
for paper-check services of 6.0 percent, including a 5.0 percent 
increase in forward-check collection fees and a 9.6 percent increase in 
return-services fees (see table 12). In addition, prices for payor bank 
services will increase 8.1 percent. To encourage further the adoption 
of electronic presentment, the Reserve Banks will decrease 12.5 percent 
the price for Check 21 items that are presented electronically, and 
increase 3.1 percent the price for Check 21 items that are presented as 
substitute checks. In addition, the Reserve Banks will offer a $0.003 
discount per check presented through FedReceipt products to further 
encourage their adoption. This discount will be applied to fees for 
checks deposited with the Reserve Banks.

                       Table 12.--2007 Fee Changes
                                [Percent]
------------------------------------------------------------------------
                         Product                            Fee change
------------------------------------------------------------------------
Paper check.............................................             6.0
    Forward collection..................................             5.0
    Returns.............................................             9.6
Payor bank services.....................................             8.1
Check 21:
    FedForward (electronic endpoints)...................           -12.5
    FedForward (substitute check endpoints).............             3.1
    FedReturn...........................................             0.0
    FedReceipt products.................................     \a\ -$0.003
------------------------------------------------------------------------
\a\ FedReceipt customers will receive a $0.003 discount per check
  presented. The discount can be used to offset fees for checks they
  deposit with the Reserve Banks.

    The primary risks to meeting the Reserve Banks' budgeted 2007 cost 
recovery are higher-than-expected declines in paper check volume and 
slower-than-expected adoption by paying banks of FedReceipt products, 
as the manual processes associated with printing substitute checks and 
preventing duplicate checks from entering the processing environment 
will exert upward pressure on staffing levels and costs. Competitive 
pressure from direct electronic exchanges also poses a risk to the 
Reserve Banks' projected cost recovery. Other risks include 
unanticipated problems with check office restructurings or other major 
initiatives that may result in significant cost overruns.
    F. FedACH Service--Table 13 below shows the 2005, 2006 estimate, 
and 2007 budgeted cost recovery performance for the commercial FedACH 
service.

                            Table 13.--FedACH Pro Forma Cost and Revenue Performance
                                                  [$ Millions]
----------------------------------------------------------------------------------------------------------------
                                                                                                    5  Recovery
                                                                                                    rate after
              Year                  1  Revenue       2  Total      3  Net income   4  Target ROE  target ROE  [1/
                                                      expense      (ROE) [1 - 2]                     (2 + 4)]
                                                                                                     (percent)
----------------------------------------------------------------------------------------------------------------
2005............................            87.4            72.2            15.2            10.0           106.4
2006 (estimate).................            89.7            81.2             8.5             7.5       \a\ 101.1
2007 (budget)...................            99.9            89.5            10.4             8.8          101.6
----------------------------------------------------------------------------------------------------------------
\a\ Including FAS 158, the estimated cost recovery for the FedACH service is 72.6%.

    1. 2006 Estimate--The Reserve Banks estimate that the FedACH 
service will recover 101.1 percent of total expenses and targeted ROE, 
compared with the budgeted recovery rate of 101.6 percent. The Reserve 
Banks expect to recover all actual and imputed expenses of providing 
FedACH services and earn net income of $8.5 million. Through August, 
FedACH commercial origination volume is 11.9 percent higher than the 
same period last year. For full-year 2006, the Reserve Banks estimate 
that FedACH originations will grow 12.4 percent, compared with the 
budgeted growth of 7.6 percent, because of greater-than-expected volume 
from Electronic Payments Network (EPN), the other ACH operator.
    2. 2007 Pricing--The Reserve Banks will maintain processing and 
service fees at current levels with one exception. The monthly 
subscription fee for the Information Extract File will increase from 
$10 to $20.\45\ Pricing for this service has remained at $10 since its 
inception in 1998, and the higher price more accurately reflects the 
value of the file to the receiving depository institution.
---------------------------------------------------------------------------

    \45\ The Information Extract File provides depository 
institutions with a file containing financial electronic data 
interchange information if their service providers cannot process 
and translate such information.
---------------------------------------------------------------------------

    The Reserve Banks project that the FedACH service will recover 
101.6 percent of total expenses and targeted ROE in 2007. Total revenue 
is budgeted to increase $10.2 million from the 2006 estimate. 
Nationwide ACH volumes are expected to continue growing at double digit 
rates. This expected growth is largely attributable to volume increases 
associated with electronic check conversion applications--including 
checks converted at lockboxes or at the point of purchase. In early 
2007, ACH rule changes will permit checks to be converted in processing 
centers or back offices, spurring further growth in ACH check 
conversion volume. The Reserve Banks expect FedACH commercial 
origination volume to grow by 12.0 percent. The primary risk to meeting 
the Reserve Banks' budgeted 2007 cost recovery is the loss of large ACH 
originators to EPN. Total expenses are budgeted to increase $8.3 
million over the 2006 estimate. The Reserve Banks have budgeted 
increased costs for product development and service

[[Page 67616]]

initiatives, such as FedACH risk management services.
    G. Fedwire Funds and National Settlement Services--Table 14 below 
shows the 2005, 2006 estimate, and 2007 budgeted cost recovery 
performance for the Fedwire Funds and National Settlement Services.

        Table 14.--Fedwire Funds and National Settlement Services Pro Forma Cost and Revenue Performance
                                                  [$ Millions]
----------------------------------------------------------------------------------------------------------------
                                                                                                    5  Recovery
                                                                                                    rate after
              Year                  1  Revenue       2  Total      3  Net income   4  Target ROE  target ROE  [1/
                                                      expense      (ROE) [1 - 2]                     (2 + 4)]
                                                                                                     (percent)
----------------------------------------------------------------------------------------------------------------
2005............................            67.3            55.2            12.1             7.9           106.7
2006 (estimate).................            71.3            59.7            11.6             5.6       \a\ 109.1
2007 (budget)...................            72.7            64.7             8.0             6.3          102.3
----------------------------------------------------------------------------------------------------------------
\a\ Including FAS 158, the estimated cost recovery for the Fedwire Funds and National Settlement Services is
  78.6%.

    1. 2006 Estimate--The Reserve Banks estimate that the Fedwire Funds 
and National Settlement Services will recover 109.1 percent of total 
expenses and targeted ROE, compared with a 2006 budgeted recovery rate 
of 105.4 percent. The greater-than-expected recovery rate is primarily 
attributed to higher-than-expected electronic connection revenue and 
NICB, which offsets slightly lower-than-expected fee revenue, as well 
as lower-than-budgeted operating costs. Through August 2006, online 
funds volume was 1.2 percent higher than it was for the same period 
last year. For full-year 2006, the Reserve Banks estimate that online 
funds volume will remain flat, compared with a budgeted growth of 3.0 
percent, as they lose market share to CHI